October ISM Manufacturing Report Paints a Bleak Picture

The U.S. ISM Report that was released yesterday paints a very bleak picture - factory activity is the lowest since 1982 (see TradetheNews). Here is a summary of the numbers released today.

OCT ISM MANUFACTURING INDEX: 38.9 V 41E

• Prices Paid: 37 V 48E
• Employment Index: 34.6 v 41.8 prior
• New Orders Index: 32.2 v 38.8 prior
• Inventories Index 44.3 v 43.4 prior

What this shows is that inflation is a thing of the past, but unfortunately so is employment. As new orders have clearly slowed, employment has followed and unemployment is likely to continue to rise in the manufacturing sector.

My Analysis

When looking at this recession compared to previous ones, there is one particular structural change that I would like to point out. That is the increased efficiency of technology and its impact on supply chain management.

In the past, rising inventories was a clear tip off that recession was around the corner. Manufacturers didn't have the analytic tools to anticipate changes in demand and would simply continue to produce. Their customers would also continue their purchases, although they would see qualitative signs of slowing as their retail customers gave them feedback through day to day purchases. By the time that feedback reached manufacturers through smaller bulk purchases by their customers, the factories had amassed large inventories.

Today, things work differently. Companies now try to anticipate changes in demand. They do this both to avoid the classic problem of building inventories and because the range of products today includes a far higher percentage of products that can be obsolete in a few months. For example, a furniture manufacturer can afford to hold inventories for longer than a chip manufacturer, who is subject to technological improvements in a short period of time.

The end result is the early anticipation of a recession through cost cutting. So what we are likely to see earlier in the cycle than we used to is higher unemployment and lower prices. We have seen this through the crash in commodity prices and the downward pressure on the Baltic Dry Index. There is a clear negative feedback loop and this can be seen in the sudden drop in demand. Most of the large manufacturers use the same supply chain management software, or different software that uses very similar factors. As they all signaled weaker demand ahead, the drop in prices and the rising unemployment became almost a self fulfilling prophecy. As you can see below, prices dramatically shifted direction over the past few months.

Customer inventories, however, have moved up, with factory inventories coming in higher than expected but in a contracting trend. This time around it's the customer's inventories that are piling up and are currently considered to be too high by the Institute for Supply Management. That number sitting at 55.0 this month is the only number above 50.

What we may experience is that the environment reverses and it is now the factories that have the upper hand on its customers when it comes to forecasting demand. As I have said, methods for supply chain management have vastly improved on the factories side, but in most cases retail outlets still rely on gauging demand on a day to day basis through a qualitative approach. Obviously this doesn't apply to larger retail outlets such as Wal-Mart (WMT), but even so, they are likely more vulnerable to rising inventories than their suppliers.

click to enlarge images

Official Source

Other countries also released their own Manufacturing PMI numbers Monday morning:

• Britain 41.5 vs 40E
• EU 41.1 vs 41.3E
• Swiss 47 vs 45.5E

Disclosure: none